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Monthly Archives: December 2011

Today’s announcement that Sears will close 100 to 120 stores should come as no surprise. Anyone who has visited a Sears Canada store recently can testify to the terrible store layouts, poor merchandise presentation, and abysmal customer service. And that’s before we even get to the poor quality of much of the merchandise.

At one time, Sears was a differentiated retailer. Sears meant quality and value for money, it meant customer service, and it meant well-maintained stores. Somehow, somewhere, it all went terribly wrong.

The Sears story is indicative of much of what ails the retail sector today. Here, in Canada, it is hard to find a retailer where a focus on the customer and their needs is the norm rather than the exception. At least the big box retailers like Wal Mart don’t pretend to be anything other than what they are; the lowest prices, everyday.

Every retailer, it seems, attempts to compete on price. Except, of course, the “upscale” establishments which position themselves as differentiated retailers where superior quality and service command a premium price. The industry has succeeded in fragmenting itself into two extremes: those who compete on price and those who compete on service and quality. There appears to be little in between.

The Sears story is instructive because it shows what can happen when a firm has little sense of who it is and what it stands for. If low price is to be the basis for competing, then that had better be backed up by an industry leading cost structure in order to preserve margins. Most importantly, this low-cost structure must not be achieved by sacrificing what customers perceive as valuable.

Walk into most any Wal Mart and you will find orderly stores, customer service, and ample stock. Wal Mart achieves it low-cost through a value chain whose configuration enables efficiencies and low-cost operations without sacrificing the things its customers value. Sears, in contrast, believes that the way to lower cost is to cut out the things that customers value and their sales have suffered as a result.

A firm can offer a low price because it has designed and configured its value chain to operate at the lowest total cost. It knows who its customers are, what they value, and what capabilities it needs to offer that value. The cost advantage such a firm gains can be passed through to customers in the form of lower price. A competitive firm, like Sears, which does not have the same value chain, does not have the same cost structure; its costs must therefore be higher. For Sears to compete with Wal Mart, it must cut its prices, which decreases its revenues. To make up the profit shortfall, it must then cut back on things like customer service, merchandise quality, and store organization – the very things customers value.

If a firm chooses not to compete through achieving a cost advantage strategy, its only other option is to differentiate itself. Differentiation as a strategy implies offering unique value to customers that commands a bigher price. Being “stuck in the middle” (Michael Porter’s phrase) between the two strategic pathways is not an option, as Sears is regretfully finding out.

Sears is now at a strategic crossroads. Its strategy, whatever that was, has failed. It must remake itself and reposition itself in the marketplace. This is the purpose of strategy – the deliberate search for a plan of action which will lead to a competitive advantage and compound it. Offering cheap prices at the expense of customer value is no substitute for strategic thinking.

Why should a firm pursue standardization? There are two reasons: it reduce costs and it surfaces abnormal or non-standard conditions, the addressing of which constitute powerful organizational learning.

Taking the cost issue first, firms pay a significant cost penalty when there is no concept of standardization. Standardizing something really means defining your “normal.” When something is not standardized, whether it be a product, process, or service, variability is likely to ensue, and that variability results in unwanted costs.

When normal is not defined, anything goes. For a firm, this may mean that processes are executed differently by various persons, that products are developed using an ad-hoc process, that services delivered in varying ways – the list goes on and on. All of this variation results in non-standard outcomes and unwanted costs associated with addressing the undesired results.

The second main reason for standardizing is that when something is standardized and normal defined, abnormal becomes apparent. This allows a firm’s personnel to undertake problem solving and learning, leading to corrective action designed to remove the causes of the abnormal condition and prevent its recurrence.

Abnormal conditions are the precursor to undesired outcomes and results. When they are detected early, an undesired outcome can often be prevented through a timely intervention. Only when standardization exists and a normal state defined can an abnormal condition be identified.

Can you imagine a non-standardized world? A world where the colour of traffic lights is left to the discretion of each municipality, a world where your banking transactions are carried out differently be each teller, a world where your car manufacturer builds your car differently in each of its manufacturing plants? We often take standardization for granted, and in every firm there are often signficant opportunities for standardization of products, service and processes that can lead to dramatic cost savings. Failing to identify and pursue these gaps can result in signficant profit erosion and inefficiency.

The latest economic data shows firms (and consumers) are still hoarding cash and witholding investment spending.This despite continuing corporate tax cuts both here in Canada and the USA. Why is this important? Because one man’s spending is another man’s income. If we cannot induce spending, the economic recovery will remain stalled and we will not get back to GDP growth on trend.

There is no mystery here – firms will always err on the side of caution if there is no forseaable return on investment spending. What would provide an incentive to invest and spend is, of course, an uptick in demand. And, without investment spending, demand is likely to remain depressed – sort of a chicken or the egg scenario.

Paul Krugman has written extensively that we are in a liquidity trap and that the normal rules of economic logic don’t apply. The way out, according to Krugman and other macroeconomists, is for government to step into the breach and stimulate demand by doing what private enterprise won’t do – invest and spend. Then, as employment and incomes rise, aggregate demand will rise and induce further spending from private firms.

Despite the stagnant and bleak outlook, this is a good time for firms to part with some cash and invest in their future. Investments which enhance a firm’s ability to compete once demand comes back are wise decisions. Thus, firms should consider spending on initiatives which enhance core competencies and capabilities, infrastructure, and new relationships and alliances.

The time to invest is now – while there is still time to do so. Waiting until the economy revives leads not only to economic stagnation but also to stagnation in thinking. Firms should use this “downtime” wisely to ensure they are prepared for the future.

It’s often instructive to do thought experiments. They can provide insight as the mind puzzles through a problem. Problems such as how does a firm increase or maximize its profit.

Most people answer this question in one of two ways: either increase sales or reduce costs. I prefer to consider the problem strategically, working backwards from the profit equation where P (Profit) = TR – TC (TR = Total Revenue; TC = Total Costs).

A firm’s revenues are a function of market structure, while it’s costs are a function of its input costs and how efficiently they are transformed into output. While costs drive pricing, and pricing will influence the quantity sold, firms may have limited market power to be able to influence or control the price they charge.

The closer one’s market structure is to perfect competition, the less a firm has to decide about price. Because a firm operating in such a market is a price taker, the only decision for such a firm to make is to determine what is the optimal quantity to produce. If the firm cannot produce an output quantity which allows it to cover its variable costs, it should, of course, shut down.

Fortunately, few firms are competing in perfectly competitive markets. There are, however some highly fragmented industries which approximate perfect competition. In these cases, pricing in the long run may be driven dow to the long run minimum average total cost, making it very difficult to operate profitably.

At the opposite extreme to perfect competition is monopoly. The monopolist is able to restrict output and drive price higher. The monopolists profit maximizing point is where marginal revenue equals marginal cost.

In between these two extremes, we have varying degrees of imperfect competition, including oligopoly and monopolistic competition. As we move further away from perfect competition, the need for firms to differentiate themselves and their offerings becomes a key component of a strategy for building a competitive advantage.

Differentiation allows a firm to shift the market demand curve rightward, in its favour. This allows the firm to charge a price premium for its differentiated offerings. Thus, a firm can make a higher profit at the same output quantity because its offering is now more valuable to customers.

Price is the translation of a strategic position. While costs will determine margin, they should not always determine pricing. Put another way, if you are not different, you had better be cheap, since the only thing left to compete on is price – the price that the market is willing to pay for undifferentiated products and services.

On Christmas Eve, it’s well to think of how severe this recent recession has been. Here in Canada, employment levels are still well below the pre-recession numbers, and although some recovery in employment has occurred, one is left to wonder when and if we will ever get back to pre-recession levels.

As the graph above shows, the adjusted unemployment rate in Canada is beginning to rise again. This is a worrisome sign, the more so since the federal goverment has been promoting a policy of fiscal austerity which is supposed to eventually result in economic expansion and growth.

The current infatuation with “expansionary austerity” is likely to have a dampening effect on any economic recovery which may be taking place. Lessened spending is antithetical to what is needed to stimulate greater aggregate demand and growth. Contractionary economic policies are just that – contractionary – and any attempt to “spin” them as otherwise goes against all macroeconomic logic.

In the face of depressed demand, firms are likely to maintain an ultra-cautious approach to investment and spending. The latest Canadian GDP numbers for October show a flatlined economy, reversing four previous months of moderate expansion. Since the Canadian economy is now heavily resource-based, it is more susceptible to lower aggregate demand for resource-based commodities.

Sound macro requires us to adopt a stimulative approach to the current situation. Anything that will help the marginal propensity to consume should be undertaken. Investments in infrastructure and education that will pay back in the future should be made. Debt reduction can be undertaken in the future once the economy is back on track and unemployment levels reduced.

Firms should not get too comfortable if they are showing good profit levels, as many are. Many firms have ehnaced their profitability in this recession due to cost-cutting and downsizing. This hardly leaves such firms well-positioned for the future when demand begins to return. These firms will be faced with competing in a changed environment which will require new thinking, new offerings, and new capabilities. Extrapolating what worked in the past into a new environment is not a good strategy for building competitive advantage.